On increasing market valuations

A crowded market poses challenges for Private Equity firms looking to secure good deals. A significant issue the industry currently faces is increased company valuations, and in this article, we explore some of the reasons why the sector is paying more now than ever for assets.

Following the most recent financial crisis, interest rates have remained low, and investors continue to seek more attractive options in which to invest. An influx of capital means the industry is exceptionally buoyant (according to an article by Reuters the sector is currently sitting on $1.2 trillion worldwide to invest), but it has also created a supply and demand issue with more capital available than businesses for sale.

The result is often bulging funds with record amounts of un-invested capital (commonly referred to as ‘dry powder’) meaning fierce competition for deals and upward pressure on valuations. Recent figures from the US show that PE firms are paying more for assets now than in the pre-crisis boom with transactions secured at circa 10.5 times EBITDA in 2018 compared to circa 9.5 times in 2007.

This new and intense competition in the sector means that PE firms find themselves under pressure to invest, bringing the potential risk of rash or sub-optimal decision-making. Against this backdrop, it’s critical that the industry applies caution. Maintaining a tight grip on diligence is essential to avoid investing in businesses which don’t meet all standard criteria.

Similarly, debt, cheaply available due to on-going low-interest rates, must be obtained prudently, as managing it can be a major headache in a downturn. Corporate defaults can also pose a significant threat to overall PE fund performance and should always be a consideration for a PE firm when securing debt packages.

So, how do we make the most of the exciting opportunity we have while also striving for high performance? The key is to find the right fit by investing in companies that meet standard criteria but which are also a suitable match for you and your investors. Investment decisions should focus on whether a company has enough intrinsic value and ability to sustain profitable and robust growth to support and justify a higher valuation.

Business cycles and credit market conditions play an important role in the functioning of financial markets, and private equity is no different. It has been shown that investment activity and deal structures change as a result of changes in the economic cycle. However, while potential macroeconomic turbulence may call for increased prudence in decision making, where an appropriate investor-company fit exists, profitable and successful investment and sustainable growth remain possible.